Monday, January 23, 2012

Romer on Regulation

I ran in to a lovely little paper on regulation, thinking about financial regulation, from Paul Romer.

In my thinking about financial regulation, I've been heading toward the idea that we should regulate assets, not institutions; that regulations should be few and simple; that regulations should be rules, not licenses for regulators to do whatever they want; that rights and recourse for the regulated are important limits on the abuse of even well-intentioned power; and that pre-commitment, limiting the power of regulators ex-ante to bail out ex-post is important.  That view is in an earlier blog post, and in an article in Regulation. More to come of course.

Paul comes to about the opposite conclusion, in a very thought-provoking way.

Paul cites Myron Scholes' law, "Asymptotically, any finite tax code collects zero revenue," to suggest that simple clear rules will never work. He cites the FAA's regulation of flight safety and the Army's  integration as successful examples in which regulators, given wide latitude but rewarded on results achieved. And he cites the OSHA as an example of the hopelessness of a rules-based approach. For example,
The height of stair rails shall be as follows:
Stair rails installed after March 15, 1991, shall be not less than 36 inches (91.5 cm) from the upper surface of the stair rail system to the surface of the tread, in line with the face of the riser at the forward edge of the tread.
Stair rails installed before March 15, 1991, shall be not less than 30 inches (76 cm) nor more than 34 inches (86 cm) from the upper surface of the stair rail system to the surface of the tread, in line with the face of the riser at the forward edge of the tread.
Paul comments:
 It is tempting to ridicule regulations like these, [you bet! -JC] but it is more informative to adopt the default assumption that the people who wrote them are as smart and dedicated as the people who work at the FAA. From this it follows that differences in what the two types of government employees actually do must be traced back to structural differences in the meta-rules that specify how their rules are established and enforced. The employees at the FAA have responsibility for flight safety. They do not have to adhere to our usual notions of legalistic process and are not subject to judicial review. In  contrast, employees of OSHA have to follow a precise process specified by law to establish or enforce a regulation. The judicial checks built into the process mean that employees at OSHA do not have any real responsibility for worker safety. All they can do is follow the process.
I'm not totally convinced. In part, I'm a pilot, aircraft owner, and flight instructor, so I have a slightly different view of the FAA than the average air traveler. Yes, commercial jet travel is remarkably safe. But it's not at all obvious how much of this comes from the FAA regulation, especially at the margin, and how much from technical progress in aircraft and pilot training.

The surest way to ensure flight safety is to make sure nobody takes off in the first place. That often seems to be the FAA's attitude towards the light aircraft that I fly.

For in fact the social optimum balances flight safety against the economic and personal advantages of flying. For commercial aircraft, the airline companies and the flying public are loud enough to be heard. For light aircraft, we are not. No FAA employee was ever fired for the number of flights that didn't happen, the number of pilots who gave up flying, the technical innovations that didn't happen under his watch.

And the Federal Aviation Regulations, plus the FAA's love of paperwork, can make the OSHA stair railings look positively simple. In fact, there are rules, there is right of appeal, and by and large the FAA does not have the authority to come out to your airport and shut you down if it doesn't like what you're doing. (It can, and does, dig in to the paperwork to find inevitable flaws.)  And these are good things!
Some of the FAA's "safety" regulation has the opposite effect. For example, automobile engines are now more reliable than light aircraft engines. But they and their parts are not "certified," a long and expensive process. So we use what's certified. Airplane-to-airplane collision avoidance systems have been on the market for several years that cost $1000, yet the FAA's system ("ADS-B") which will be much more expensive is taking years to come out.

I'll say this for the FAA: it's all much worse in Europe. And the FAA is not  corrupt. Wide latitude to make decisions as you see fit, and to selectively enforce a forest of rules, is usually a surefire recipe for corruption.

Looking forward to financial regulation, it seems inevitable that regulators, given wide latitude, and  charged only with "safety" and not "growth" will mistake the fortunes of the financial system with the fortunes of individual, existing, institutions, and will quash innovation and competition in the name of safety. The Fed's proposals to implement Dodd-Frank (comments here) seem already very clear in that direction

Scholes' rule is fun too, but the corollary is that any society will arbitrarily expand the complexity of its regulation and the deviousness of lawyers and accountants to avoid it, until nobody actually does anything anymore and the society grinds to a halt.

So, it's a great and thought provoking read, and it's making me think a lot harder, though I'm not totally convinced.