Notes on Regulatory Capture Speech

Well, today was the big day that I gave my speech on Regulatory Capture Theory at the Mackinac Center for Public Policy. It went better than average - though I'm abysmal at public speaking. Well at any rate, somebody asked me for my notes after the speech, so I figured there might be someone else out there who would also be interested in them:

Regulation almost always produces “winners” and “losers” (broadly, those who are better with the regulation, and those who are worse off). What determines who wins and who loses?

The two views of regulation

• Public interest theory posits that regulation comes into existence when the general public recognizes an inefficient or inequitable allocation of resources (aka market failure), and desires this failure to be corrected. Then, the political system responds to this desire by enacting regulation in the benefit of the public.
  
  
  
  • For example, people's awareness of spilled costs caused by incompletely defined property rights was a proximate cause of the formation of the Clean Air Act and the Environmental Protection Agency
    
  • Regulation serves the public interest, and is enacted for this reason.
    
  • Assumes: Markets are fragile and require outside, top-down planning to correct errors that will naturally occur.
    
    
    
    • Politicians are neutral and entirely other-serving.
      
    • Either the general public, the politicians or the members of the firms being regulated have perfect knowledge, since the regulation is unlikely to result in a net-gain otherwise.
    
    
  • Problems: Does not give a rich or detailed account for the process of how regulation is formed.
    
    
    
    • If markets do not require extensive top-down corrections, this can be an objection. i.e. it assumes that a solution is possible for this problem.
      
    • Many industries which are not natural monopolies and do not have large spillover costs cannot be accounted for by this theory, since they are heavily regulated, such as taxicabs, bars, and trucking industries.
    
    
  • This theory does not see much support because of these and other problems.
  
  
• Capture Theory treats regulation as a good that is supplied by politicians and demanded by those who are affected by it.
  
  
  
  • The good in question is the ability to legitimately coerce, which makes it a very unique good, which is held by a monopoly.
    
    
    
    • It is desirable to consumers in the industry because they can correct the market failure or force the industry to offer lowered prices.
      
    • It is desirable to the firm because they can create barriers to entry (such as licensing fees) which protect them from costly price battles by preventing entry of rivals.
    
    
  • The group that the regulation will end up favoring (the “winner”) will tend to be the group that has the highest per-capita stake in the matter. This is because the individuals in this group have a higher demand, and so are likely to make more productive investments than the individuals in the other group. And if the group with the lower per-capita stake has a higher overall stake in the matter, this would mean that there are more individuals in this group, and so even though efficiency would necessitate that they be the “winners,” transaction costs in the form of collective bargaining barriers will prevent them from acting decisively.
    
    
    
    • So, even if the regulation was created with the vague intention of the greatest good for the greatest number, it will end up being captured by the high per-capita stake group, which almost always be the business owners, for obvious reasons.
    
    
  • Another barrier to the low per-capita group is that they have a knowledge problem – they don't know who to direct their rent-seeking behavior towards. This is precisely because they are the low per-capita stake group, since it isn't worth it to invest the time to gain knowledge about who's in charge and how the system works.
    
    
    
    • On the other hand, people working in the industry will know a lot about the system and who's in charge. There are two reasons for this. One is that it is worth it for them to make the investment to understand the system. There was a lobbyist who says he didn't fail to read a single bill in his career until Obama's stimulus bill.
      
      
      
      
      
      • Tullock gives a speech to a crowded room, person leans over and tells him they're almost all lobbyists.
      
      
      • And second, because, in the supply of regulation for industry X, who is most likely to make a compelling argument as to what the problems are in industry X and how to solve them most efficiently? Who has comparative advantage in the supply of this regulation? People from the industry. This creates a revolving door between industry and government, so that people from industry X know a lot about the regulation process, and people from the regulation process of industry X know a lot about the industry. (Timothy Geithner, for example, has worked in government and in the private sector back and forth.)

This bill has potential for regulatory capture

• On June 30th, Treasury Department today released draft legislation outlining a central pillar of the Obama administration’s financial regulatory overhaul: the creation of the Consumer Financial Protection Agency (CFPA), an independent regulator with broad authority over “any financial product or service” used by consumers.
  
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  It's mandate is to promote transparency, simplicity, fairness, accountability, and access in the market for consumer financial products or services.
  
  

• In The Theory of Economic Regulations, George Stigler says that, though subsidies are the most obvious political benefit, they are not the most desirable. This is because it is extremely difficult (if not impossible) to exclude the entire industry from receiving the subsidy, so not only does it not give individual firms advantages over their competitors, but it may even lure in additional competitors. As the number of people in the market grows, the individual firm's share of the subsidy money may decrease over time, as well. The most desirable political good is exclusion of competitors, which saves them from harmful price wars.
  

• This is frequently done by barring competitors from starting up a firm by creating barriers to entry, such as through licensing fees.
  
• Another means is to pass a regulation which restricts a certain kind of action, or changes the rules of the game in some general way so that it appears to apply uniformly, when in fact their competitors will be unevenly affected. For example, walmart is supporting Obama's health care plan because target has more expensive health care coverage, and Dow supported the cap and trade bill because they are relatively clean polluters.
The CFPA will have the tools to severely restrict the business of certain firms, especially those deemed risky, since it has the ability to, “Prescribe rules and issue orders and guidance as may be necessary or appropriate to enable it to administer and carry out the purposes and objectives of [its] title,” with the objectives being:



• consumers have, understand, and can use the information they need to make responsible decisions about consumer financial products or services;
  
• consumers are protected from abuse, unfairness, deception, and discrimination;
  
• markets for consumer financial products or services operate fairly and efficiently with ample room for sustainable growth and innovation; and
  
• traditionally underserved consumers and communities have access to financial services.
One power the agency will have is to gather and compile information, “regarding the organization, business conduct, and practices of covered persons” (sec. 1023). There also is a confidentiality clause, that The Agency has free reign to determine what information it discovers will be made public and what will not, and it has full right to keep it public.



• This is information that it uses to construct its vision of how customers are being serviced, and this view is what will determine the rules and regulations it will issue – so it has the ability to keep completely private as to what the motivations for it's restrictions are. Even if this doesn't result in The Agency not telling that it is making a rule in order to elicit a bribe, it means that it could allow for a greater disparity between it's intents for creating a rule, and what the public would find a satisfactory justification/what the public is told is the reason, by leaving out relevant findings.
Furthermore, lobbyists will have a much easier time lobbying to this agency, which is a sort of a one-stop-shop for lobbyists, since consumer financial regulation is currently divided between the Federal Reserve, FDIC, Office of Comptroller of the Currency, Office of Thrift Supervision, Federal Trade Commission, and National Credit Union Administration. Another objection: of the 5 members, 4 appointed by the President and confirmed by the Senate, and 1 the Director of the National Bank Supervisor, so they will not be biased towards the industry. Yet President Grover Cleveland appointed a railroad ally named Thomas M Cooley as the first chairman of the ICC (a classic example of Regulatory Capture).



• First, simply rubber-stamping railroad industry decisions. Then, after the turn of the century, when the ICC began actively discouraging competition in the railroad industry. The ICC had the power to decide when new firms were allowed to enter the railroad industry, and by the 1920s, the FCC was actively working to discourage competition and push up railroad rates.
One objection that could be raised to this approach is that, if the regulation will benefit the high per-capita stake business interests, why are financial industries objecting vehemently to the CFPA act?



• One answer is that Capture Theory does not need to say that regulation begins with the purpose of benefiting the high per-capita group. This group may appear to be the losers when the regulation is first introduced. The reason for this can be understood if the suppliers of regulation (politicians) are seen also as demanders of it, since they stand to benefit from its passage in the form of votes. To this end, they will want it to at least appear as if the bill is going to benefit the largest number of people, which almost always is the consumer.
  
  
  
  • However, Capture Theory does necessitate what will happen to this regulation after its passage – it will begin to work for the members of business, almost certainly at the expense of the consumer, since it could involve choking out competitors who can satisfy consumers more efficiently.

Why this is bad

• Rent seeking diverts resources away from wealth production and towards the transfer of wealth – it has an opportunity cost.
  
• It means the agency will be difficult to get rid of, since those who have captured it will want it around even when it is obsolete by the standards of its intended purpose. The ICC is an example of this, which continued to exist with a "regulated monopoly" structure, even after 1920 when trucking and air-borne freight became competitors of the railroad industry.

Suggestions to fix it

• Remove the confidentiality clause
• Remove the ability to exempt firms from mandates by the CFPA and any other consumer protection law.