Can deregulation restore our economic dynamism?
can we deregulate our way out of our inability to build?
One reason for the explosion of bureaucracy and red tape across the world is the dramatic increase in the scope and detail of regulations and laws that govern most activities today. For example, the primary legislation governing financial services in the United Kingdom has increased tenfold within a generation, and obtaining approval for large projects anywhere in the West takes years (e.g. the EU, the United States and Britain). Charles Schultze has explained the primary reason for this dynamic (emphasis mine)1:
if specific regulations are the only bar to prevent social damages, the regulating agency must provide a regulation for every possible occasion and circumstance. First it will take twenty-one pages to deal with ladders and then even more as time goes on. Social intervention becomes a race between the ingenuity of the regulatee and the loophole closing of the regulator, with a continuing expansion in the volume of regulations as the outcome.
An obvious solution to this problem is deregulation. Some types of deregulation, such as deregulation of project approval, new firm entry into regulated domains and occupational licensing, will help. However, the deregulation of day-to-day operations is unlikely to make the system less complex or more agile. In fact, the deregulation of industries (public or private) where firms are not subject to the risk of bankruptcy and failure is likely to make things worse and may even lead to looting.
Deregulate entry, project approval and licensing
Of all the possible forms of deregulation, the ones that will most improve the dynamism and agility of the economy are:
Reducing barriers to new firm entry
Speeding up approval of projects
Removing occupational licensing requirements
The dynamism of the US economy has declined dramatically during the last few decades because of the decline in the rate of entry and exit of businesses. Transformational change of any system requires relatively unrestricted entry of new players into the system, as incumbents rarely take on the level of risk that any such transformation entails.
The best example of this is how Japanese industrialisation during the Meiji era was “attained not by the same business groups expanding over time but by
frequent entries and exits of newcomers”2. In fact, as the below graph shows, very few millionaires from the late Edo period or even the early/middle Meiji period remained millionaires at the end of the Meiji period.
Operational deregulation does not reduce complexity
It is natural to think that reducing the scale and scope of regulations that govern the day-to-day operations of any activity should reduce the complexity of the control process. However, this is rarely true, as the complexity of most modern bureaucratised domains stems from more fundamental reasons than just the prescriptions of the law and the demands made by the regulator. The demands of insurers, auditors and compliance professionals (both internal and external to the organisation) and the desire for senior managers to control and place the responsibility for compliance on operational staff are just a few reasons why organisations rarely simplify and remove existing control processes just because the law or their regulator allows them to.
In fact, complexity and built-up ‘legacy code’ tends to create special interests within and outside the organisation. As Andrew Haldane observed, those “with large amounts of human capital invested in complexity” have the incentive to preserve this complexity.
Another idea that has been popular over the last few decades is a move away from an overly prescriptive legal and regulatory regime towards a more functional regulatory regime where the details of the implementation of the regulatory directives is left to the discretion of the regulated entity. Paradoxically, deregulation of this nature can even increase the bureaucratic load, as a paper by Storkersen, Thorvaldsen, Kongsvik, and Dekker shows in great detail. I recommend reading the entire paper, but a brief summary of the reasons due to which this can occur are:
The desire for management to push the burden of compliance on operational personnel and to avoid blame if anything goes wrong.
The increasing demand for auditability, measurability and transparency and the need to document everything.
the demonstration of accountability towards financial backers, insurance companies, and even the media and the public.
the limitations of standardised software that errs on the side of increased complexity.
If operational deregulation is to reduce complexity, it will do so in new firms and new organisations that can start from a clean slate. This is yet another reason why we must build new systems rather than reforming old systems and why deregulating the entry of new firms is so important.
Deregulation without the risk of failure will lead to looting
Even in today’s capitalist economies, most organisations are shielded from the risk of failure by the state - some because they are explicitly run by the state (e.g. the NHS in Britain) but many because they are implicitly protected by the state and bailed out in times of crisis (e.g. banks in 2008, energy distributors in the current energy crisis). Deregulating and reducing the intensity of control over these firms will only enable them to loot the public purse more effectively by taking on more tail risk, safe in the knowledge that any catastrophic consequences will be borne by the taxpayer. The local councils in Britain that have lost significant amounts of money on speculative investments are a great example of this phenomenon.
However, the best example is the experience of Gorbachev, who discovered that halfway reform and removal of controls is more likely to lead to collapse than it is to renewed dynamism. Gorbachev removed controls on Soviet firms but without imposing the risk of failure or anything remotely comparable to the discipline imposed by a market economy. This “economic halfway house”3 had a catastrophic impact on the Soviet economy, with plummeting output and crippling shortages and queues.
Today, much of the capitalist West is in the same situation that Gorbachev found himself in, with organisations (both public and private) immune from the risk of failure and subject to an elaborate and complex control regime. Just like the Soviets, we incentivise managers and individuals within these organisations using a combination of targets and bonuses/incentive payments. But this is only part of what makes capitalism work. Positive incentives are the invisible hand that guides action, but they must be accompanied by what the economist Joseph Berliner has called the invisible foot of capitalism - the risk of failure. Regulations, or indeed any codified form of control, only leads to gaming which cannot be resolved via more complex control. Failure is the only reliable disciplinarian. A capitalist firm that is protected from failure is no different from a Soviet enterprise.
in 'The Public Use of Private Interest'
Ohno, Kenichi. The History of Japanese Economic Development (p. 41). Taylor and Francis.
Kotkin, Stephen. Armageddon Averted (p. 66)