The Economy is Under-Regulated and Increasingly So

Without important regulations, we risk higher prices, lower quality, and worst of all, recessions. Yes, you heard me—deregulation was responsible for the 2007-2008 financial crisis. 

Regulation is a set of penalties and rewards associated with certain actions. 

Central to regulation is the notion of feedback loops. Some actions are rewarded and therefore encouraged; others are punished and therefore discouraged. Regulation that works “well” for consumers will trigger a set of penalties for high prices, shoddy quality, or excessively risky loans, to take just three examples. 

That it will do at a bare minimum. 

Better regulation rewards low prices, high quality, and prudent risk-taking. Great regulation concentrates the consequences of decisions, both good and bad, on the relevant decision-makers. 

It turns out that such regulation exists in the United States, though its extent has been scaled back over the last hundred years or so. Indeed, a concerning deregulation trend has taken hold, dulling the bite this regulation used to have. 

I was recently reminded of deregulation’s dangers by re-reading Armen Alchian and Reuben Kessel’s underrated ”Competition, Monopoly, and the Pursuit of Money,” published in 1962. Alchian and Kessel examine a particular form of deregulation: government granting special privileges to public utilities, railroads, buses, and taxis. Municipal and state governments typically restrict entry into these industries. Additionally, the government frequently caps the profits producers in these industries are legally allowed to earn.

Entry barriers and profit caps deregulate because they break the natural feedback loops that exist in competitive markets. Unsurprisingly, results that most people would consider unfavorable usually aren’t far behind. 

The Alchian/Kessel research shows, for instance, that government deregulation leads to increased racial discrimination. 

Suppose there is a biased employer. Many people might favor a regulation that curtails his prejudicial proclivities. 

Competitive markets yield just such a regulation. 

Imagine a job paying an annual $60,000 salary. One brown-haired applicant, favored by the employer, will contribute $65,000 annually in revenue. A different blonde applicant, disfavored by the employer, will contribute $70,000. In a market regulated by profit and loss, the employer will sacrifice $5,000 annually when he makes the prejudicial choice to hire the preferred, brown-haired worker. The employer receives negative feedback.

Suppose, instead, that this employer works in an industry that has been deregulated by a government rule that caps profits. The government confiscates the additional $5,000 an employer could earn by hiring the more productive, but less preferred applicant. In such a deregulated environment, the employer is more likely to make the bigoted choice.

That’s just what Alchian and Kessel find. In those industries where the government had deregulated the market’s disciplining pressure, Jewish men were only half as likely to be employed as in those industries that were still relatively regulated environments. 

This is but one example in a virtual sea of deregulated markets.

Take occupational licensing. It creates a hedge around producers because it’s costly and time-consuming for new entrants to compete with incumbents. Predictably, incumbents increase prices and cut quality. In markets subjected to the deregulation of occupational licensing, sellers are no longer as responsive to consumer demands. 

What about rent control? Also deregulating. It ultimately generates higher urban housing prices by causing builders to shift out of low-income housing and into luxury apartments or condominiums. 

Rent control also renders landlords inert to the demands of their tenants. Compare a market regulated by profit and loss to one deregulated by rent control. In the former context, a broken lock on a tenant’s door will incentivize swift action by the landlord who fears losing his tenant to the complex across the street where none of the units have broken door locks. 

Now examine the deregulated rent control market. Rent control creates a shortage—more people want to rent than there are units available. A tenant’s door lock breaks, and he calls his landlord. The landlord responds (metaphorically): “You don’t like it here? Feel free to leave. I’ve got a hundred other folks who will take your spot tomorrow.” 

Likewise, the Great Recession was precipitated by a set of policies that socialized losses and privatized profits. Goldman Sachs had other peoples’ money to play with. Is it surprising to anyone that they gambled recklessly? 

That gambling was made possible by deregulation in another important part of the economy: credit markets. 

For years, the Federal Reserve had been tamping down on interest rates, releasing investors from the “brake” that the interest rate would have been in a free, and therefore, highly regulated credit market. In that counterfactual market, interest rates would have been higher, certain unprofitable investments would not have been undertaken, and a devastating boom-bust cycle would not have been generated.

My concern is that the United States economy is becoming more deregulated and at an increasing rate. With the United States slipping in annual “freedom of the world” reports, the most important regulatory constraints are being gradually relaxed. 

As the United States moves in a direction contrary to the rest of the world in recent decades, one wonders how far it can travel, tossing off regulations as it goes, before the car careens off the tracks.