Regulatory Failure by the Numbers

Between the current financial mess and the debate over carbon dioxide emissions controls, there is a lot of talk about regulation these days. We are told, for example, that the recession would have been prevented if proper regulations had been in place. While it is true that (by definition) the “right” regulations would have prevented bad and ensured good, it is also true that had an omniscient, omnipotent, omnibenevolent dictator been in charge, the recession would have been avoided as well. The problem, of course, is that God didn’t run for president during the last election.

Enacting the right regulations is somewhat simpler than electing an omni-everything being to run the world—but not by much. As evidence, consider all the bad regulations that got us into this mess in the first place. Also consider the oft-heard argument that financial regulators needed to “get out ahead of the innovators.” Clearly, a job for the omniscient. There is, after all, a reason why the Wright Brothers’ flight at Kitty Hawk preceded the establishment of the Federal Aviation Administration.

Any time government regulators try to do much more than lay out the basic rules of the game, unintended consequences and moral hazards rear their ugly heads. The following list of pitfalls, adapted from our book Energy: The Master Resource, is offered as a caution to regulatory enthusiasts.

1. Laws and regulations may institutionalize the tragedy of the commons. The rule of capture (which stated that oil belonged to whoever pumped it out of the ground) and related regulations led petroleum companies to drill as many wells as possible in order to get the oil before their competitors could. By encouraging companies to drill otherwise unnecessary wells, the rule led to wasted resources and sometimes to reservoir damage.

Groundwater in the United States is still a common-property resource. Because no one owns it, no one has an incentive to conserve it. Farmers in California, enjoying subsidized water prices, have been growing water-intensive crops such as rice and cotton in desert areas despite endemic water shortages.

2. Special interests lobby the government to get their products or services mandated by regulation. The mandated use of ethanol in automotive fuel is an example. In the United States most ethanol is made from corn. Farmers who grow corn and companies that make ethanol from it have heavily pressured Congress to require its use. As a further subsidy the government has banned imported ethanol even though it can be purchased from other countries for less than it costs to make it here. One unintended consequence has been an increase in food prices. As the price of corn has risen, so has corn-based animal feed and with it the price of beef, milk, chicken, and eggs.

3. Regulations can create (or destroy) entire industries overnight. The use of such power adds uncertainty and risk to the market. If risk reaches unacceptable levels, investors put their money elsewhere. The concentration of political power in Washington forces companies to lobby Congress and the White House for protection against its arbitrary use. Corporate lobbying, in turn, increases people’s distrust of the system.

4. Regulations are often the result of compromise. After concessions have been made to this powerful representative or that influential senator, the resulting law or regulation may be very different from the original proposal and have far different consequences. Politics may be “the art of the possible,” but what is politically possible may be neither practical nor environmentally friendly.

Compromise can also result in laws so vaguely worded that they can be interpreted in any number of ways. In the end it is left up to regulatory agencies and the courts to decide what a bill actually means. Their interpretations may be very different from the original intentions of the bill’s proponents.

The Clean Air Act Amendments of 1977, for example, stated that only new factories and power plants would have to meet the tighter emissions standards imposed by the act. Existing plants would continue to be regulated under the preexisting standards unless the old plants were “substantially modified.” Unfortunately, Congress did not precisely specify what “substantially modified” meant.

In 1998 the Environmental Protection Agency (EPA) sued the owners of a number of old plants, charging that the upgrades done over the years to these plants had cumulatively added up to “substantial modifications.” The owners responded, with some justification, that the EPA had originally approved their changes and that altering the rules after the fact amounted to passage of a retroactive law, something explicitly forbidden by the U.S. Constitution (Section 9, Article 3).

5. Lobbyists may support regulations as a way of hurting their competition. Utility companies with “old source” power plants, for example, welcomed the Clean Air Act’s 1977 amendments because they put potential competitors at a disadvantage by raising the cost of market entry.

Other amendments to the Clean Air Act required power companies to reduce sulfur dioxide emissions by installing scrubbers. A less expensive way to lower emissions would have been to switch to low-sulfur coal, but eastern labor unions and coal mining companies (which produce high-sulfur coal) successfully lobbied to get the requirement for scrubbers enacted into law. This resulted in a waste of resources since (otherwise unnecessary) scrubbers had to be built, installed, and powered.

In the United States during the twentieth century, government intervention in the energy market was commonly industry-driven. Firms often organized lobbying groups to obtain favorable regulation or special subsidies. Free-market economist Milton Friedman complained, “Time and again, I have castigated the oil companies for . . . seeking and getting governmental privilege.”

6. Regulations can eliminate or alter feedback. Feedback is an essential component of any activity. Imagine how dangerous the world would be for a person who had lost the ability to feel pain (as happens with certain forms of leprosy). Such a person could do serious damage to himself by continuing to walk on a badly sprained ankle or putting his hand on a hot stove without knowing it.

Government action can create a sort of institutional leprosy by weakening or even destroying the feedback loops that make it possible for companies to know whether their activities are of any value. For instance, by taxing productive companies in order to subsidize unproductive ones, governments perpetuate the waste of resources.

7. “Hard cases make bad law.” All too often, regulations are hastily written in response to the public’s demands that the government “do something” in the face of a crisis. Petroleum price controls during the 1970s are a case in point. Under the provisions of the rules, refiners could charge more for higher-octane fuels, so they were encouraged to increase the lead content to artificially boost octane ratings.

At the same time that crises lead to demands for action, they tend to increase the cost of any action. For instance, in response to the power shortage of 2000–2001, the state of California negotiated long-term contracts for the purchase of electricity. Within a few months market electricity prices dropped well below what, in the midst of the crisis, had appeared to be justified. California taxpayers bore the costs of this multibillion dollar mistake.

8. Regulations often have unintended side effects. New laws or regulations may change the incentives people face and encourage them to act in ways that the lawmakers had not foreseen.

Recall the 1977 Clean Air Act amendments that placed strict emissions regulations on new power plants, while grandfathering existing facilities. Those rules increased the costs of new plants relative to existing ones, encouraging power companies to keep older plants in service longer than they otherwise would have. Old plants are less efficient than new ones, and the result was more fuel used and more pollution created.

Fears of oil spills have led lawmakers to prohibit offshore drilling in many of America’s coastal areas. As a result, the nation must import more oil than would otherwise be the case. However, imported oil is delivered via tanker. Notwithstanding the recent tragedy in the Gulf of Mexico, tankers pose a greater oil spill danger than does offshore oil production. Similarly, forbidding drilling in onshore and near-shore locations forces oil companies to drill in more hostile areas, making accidents more likely. American coastlines are, therefore, actually less safe thanks to such legislative “protection.”

The Community Reinvestment Act and the American Dream Downpayment Act were supposed to merely increase home ownership. As should have surprised no one, however, they also set off a housing price bubble.

9. Regulators do not bear the costs of their regulations and have little incentive to ensure that the benefits outweigh those costs. The U.S. Forest Service does not pay the cost of building timber roads in the nation’s forests; the money is paid out of the Treasury. However, the Forest Service is allowed to keep some of the proceeds from timber sales. This practice provides an incentive to build logging roads into remote areas of the nation’s parks to allow timber companies access to trees that would otherwise be uneconomical to harvest.

The result, according to Tom Bethell (The Noblest Triumph: Property and Prosperity Through the Ages) is that “[b]y 1991, the service had constructed 360,000 miles of roads—eight times the length of the U.S. Interstate Highway System.” Because the cost of many of these roads exceeded the value of the timber harvested, resources were wasted. Because the link between costs and rewards was eliminated, damage is being done to thousands of acres of parkland through deforestation, loss of habitat, and soil erosion for no net gain.

10. Public officials are self-interested, and their self-interest may not always be in the public interest, as James Buchanan and Gordon Tullock, the main developers of Public Choice theory, pointed out.

For instance, managers with the federal government are often paid in proportion to the number of people who report to them. Their incentive, therefore, is to expand their departments. All too often they act in accordance with this incentive regardless of the cost to taxpayers.

More familiar are the politicians who purchase votes by using tax dollars to pay for projects of questionable value, or city officials who get kickbacks in return for construction contracts.

11. Once in place, regulations are difficult to eliminateFriedman’s “tyranny of the status quo.” For example, even though the problems with ethanol have been known for years, the regulations requiring its use have yet to be repealed.

No matter how detrimental a regulation is, or how outdated it has become, there is usually someone who benefits by it. The beneficiaries of the regulation generally have a stronger interest in keeping it in place than anyone else has in getting rid of it. As a result, they are willing to spend time and money lobbying the government to support their position. While the benefits of a regulation may be enjoyed by a relative few, the costs are often spread out among many. If the per-person cost of a regulation is only a dollar or two a year, no one has a financial incentive to travel to Washington to lobby against it. Economists call this the problem of concentrated benefits and diffused costs.

Moreover, the benefits of any particular government action are usually quite visible, but the costs are often hidden. For example, if the recycling industry receives a subsidy, the new facilities and jobs are open to public view. Those gains may be more than offset by the loss of facilities and jobs in other industries because taxes raised to subsidize the recycling industry leave consumers fewer dollars with which to purchase other goods and services.

Perhaps most important, people just do not like to admit when they have made a mistake, and politicians are no exception. If the “Smith Act” causes problems, Senator Smith is unlikely to apologize and propose that his act be repealed. Instead, the senator will probably argue that his legislation was not properly funded or enforced. In the end the law is more likely to be expanded than repealed.

For example, the laws and regulations encouraging lenders to give home mortgages to people who cannot afford to pay them back are still in effect. Rather than admit their mistake, legislators create straw men (such as Wall Street “greed”), then pass regulations to battle them.

12. Industries exert enormous influence over the government agencies created to regulate them. Reformers, believing this problem is due to an imbalance of power, often seek to remedy the situation by increasing the authority of the regulatory agency. Such measures will likely serve only to solidify the positions of those companies that already dominate the regulated business.

Industry sway over government agencies is a natural result of the incentives inherent in the regulatory process. As already noted, no one has more incentive to lobby regulatory agencies than do the companies they regulate. And regulators’ self-interest gives them a powerful incentive to listen.

There is also the “revolving door” phenomenon whereby personnel leave industry for jobs with government agencies and vice versa. Some see this as proof of corruption, but there is a simpler, less sinister, explanation. When an agency is created to oversee a business, one of its first needs is employees with knowledge of that business. Where can it go for such people but to the industry itself? Similarly, when government employees retire and wish to begin second careers, where can they go other than to the business about which they have spent their professional lives learning?

13. Laws and regulations stifle innovation. Once a particular solution is written into law, there is little incentive for companies to develop a better one. Laws are notoriously difficult to change, particularly when lobbyists’ businesses depend on the mandated solution. Even if the mandated solution was cutting-edge technology when the law was signed, technology quickly becomes outdated in a free market.

14. National regulations can create nationwide problems. In 1978 the Carter administration, mistakenly convinced that the country was running out of oil and natural gas, passed the Powerplant and Industrial Fuel Use Act. Under the act existing plants were prohibited from increasing their use of natural gas, and new plants were prohibited from using either natural gas or fuel oil. This restriction left coal as the only alternative despite the fact that coal emits more pollution and CO2 than does natural gas. (While nuclear power was also an alternative, the Three Mile Island incident, which occurred the following year, made the option politically impossible.) President Reagan lifted the restrictions on existing plants in 1981 and on new plants in 1987.

15. The existence of regulations and regulatory bodies gives people a false sense of security. Bernie Madoff’s victims, for example, were reportedly as angry with the SEC for leading them to relax their guard as they were at Madoff for taking advantage of them. Consumers who believe that government watchdog and licensing agencies weed out incompetent and fraudulent service providers may be less vigilant than they would otherwise be.