Rules and Regulators

"That government is best which governs least" - Henry David Thoreau

There are some who believe that true free markets need no assist from rules, regulators, or governments at all. Certainly, eBay has proven to be a big success with very little help from the formal organs of government. But eBay itself acts as a formidable regulator, removing members who misbehave, and eBay has incorporated strong feedback mechanisms to allow members to police each other through eBay's ratings system.

For nearly all other markets, the state plays an important role in making the market work. It prevents domination by coercion. It enforces contracts, and persecutes fraud. And in most cases, it also regulates markets in an effort to promote fairness and trust, and frequently to advance public policy aims. A huge amount of our legal code is devoted to laying down the law on how business can do business. Employment law, the Uniform Commercial Code, the bulk of environmental regulation, and an alphabet soup of Commissions (ICC, SEC, FCC, CTFC, FDIC, etc.) are devoted to telling commercial enterprises how they can go to market.

Government policy is usually drafted by legislators with good intentions and no practical experience. As we all know, the road to hell is paved with good intentions. Commercial legislation results in all kinds of unintended consequences. "Cash for Clunkers" resulted in panicked shopping, model shortages of popular replacement cars, a sudden loss of inventory in the used car market (raising prices for those shoppers), and perhaps little actual stimulus as many buyers merely moved planned purchases up, rather than injecting new money into the car sales market.

One of the most common consequences of regulating markets is a perverse phenomenom known as "regulatory capture". The industry under regulation has a far greater interest in the details of the rules than others, and does all it can to influence the result. Industry representatives rightly point out that they have far greater expertise than the lawmakers or bureaucrats, and industry uses its greater knowledge to argue for change. Pressure is exerted to get people with industry experience on the commission. Such people are likely to have contacts in the regulated industry, and have some sympathy for their concerns. Gradually, the commission evolves to mirror the industry it regulates, rather than policing it.

Does this mean the regulators, now "captured", give industry free reign? Actually, no. Industry almost always fights new rules. But once they lose the fight, they frequently find the rules give them a useful advantage. Rules take time to master, and a rule-bound industry is more difficult for new entrants to penetrate. It's been said that there are only six men in all of New York City who have the knowledge and connections to get a building permit out of the city's bureaucracy. One of those six men is Donald Trump, and it is this skill of his (not his business acumen nor his eye for a good opportunity) that made him a multi-millionare. In fact, when The Donald invests outside of NYC, his investments usually go south.

The markets that work best are those that have a large number of participants. Here is another secret to the success of eBay. It may have the largest pool of buyers and sellers in the world. Barriers to entry give unwonted market power to those who manage to scale them, raising the costs for everyone else.

This is a message that our legislators and bureaucrats rarely hear and almost never figure out on their own. As a result, regulation quickly becomes over-regulation, and those players who master the rules turn their market advantage into extra profits for themselves and extra costs for everyone else. Regulatory capture is a parasite, and one that seems to be growing.