Regulatory Insanity: The "Thing Itself," in Six Movements

1. Regulatory Insanity:The "Thing Itself," in Six Movements Michael Munger Duke University PPE Program IHS / Mercatus January 26, 2013

4. Federal Trade Commission, Washington, DC

5. The Problem is Stark…WE HAVE TO DO SOMETHING, RIGHT? Many people readily concede many of our regulations are insane, badly designed, and harmful. The difference is that many people believe the problem is one of structure, so all that is necessary is reform of the system. A better halter, a better saddle, better tack. Others believe the problem is "bad people," to which of course the solution is "good people." If we can just elect better leaders, and hire better bureaucrats, the (temporary) problem will be permanently solved.

6. Interesting Answer: Edmund Burke In vain you tell me that Artificial Government is good, but that I fall out only with the Abuse. The Thing! the Thing itself is the abuse!Observe, my Lord, I pray you, that grand Error upon which all artificial legislative power is founded. It was observed, that Men had ungovernable Passions, which made it necessary to guard against the Violence they might offer to each other. They appointed governors over them for this Reason; but a worse and more perplexing Difficulty arises, how to be defended against the Governors? Edmund Burke, A Vindication of Natural Society (1982 [1756]; emphasis added), pp. 64-65

7. The right kind of nothing

8. Why Something May be Worse than The Right kind of Nothing: The Anatomy of Government Failure Market failure paradigm: Compare actual market performance to hypothetical perfect market performance. It will fall short. Then propose implementation of hypothetical perfect policy to fix market failure. Two problems: 1. Market failure defined with reference to an allocation that is, by definition, not only unattainable but actually unknown. 2. Government failure may cause actual policy to fall short even of what is possible, and knowable.

9. Why Something May be Worse than The Right kind of Nothing: The Anatomy of Government Failure (Thanks to F. Bator, 1958) •Collective action (Olson) •Controlling Leviathan (Buchanan) •Delegation (Niskanen and NcNollGast) •Democratic coherence (Arrow, Black, and McKelvey) •Knowledge problem (Coase, Downs, Hayek, Tullock) •Rent-seeking (Krueger and Tullock)

10. 1. Collective Action Judo move: NRA. No reason to expect that pressure groups will correspond to "public interest." Successful groups: small, concentrated benefits, selective incentives Answer: Don't give the state the power to control in the first place. Because control will go astray. No necessary connection between public action and public needs.

11. 2. Scope (Controlling Leviathan) Power doesn't stay put; it metastasizes. Clean Water Act 1972. What does it apply to? All waters with a "significant nexus" to "navigable waters."; however, the phrase "significant nexus" is unclear. The statute frequently uses the term "navigable waters," but also defines the term as "waters of the United States, including the territorial seas." Scope Expansion #1: By 1985, the Supreme Court had decided what the phrase "waters of the United States" actually meant. In particular, what does "navigable" mean. Remember, the justification is interstate commerce. United States v. Riverside Bayview, 474 U.S. 121 (1985). "Those areas that are inundated or saturated by surface or ground water at a frequency and duration sufficient to support, and that under normal circumstances do support, a prevalence of vegetation typically adapted for life in saturated soil conditions," and as such is subject to the Corps' permit authority because the lands were characterized by those conditions, and the property was adjacent to a body of navigable water."

12. These were puddles. They are not rivers; puddles. Clearly not navigable, not even permanent. No flow. But after 1985, they were regulated under the interstate commerce justification. Now, expanded from "navigable waters" to "puddles." Covered under interstate commerce. Because water moves. And it might move across State boundaries.

13. Scope expansion #2: Larry Squires (veterinarian) owned land with alkaline sumps (holes catch appreciable rainwater less than once per century) in NM. Ideal for disposal of mining wastes because bed is red clay. Water evaporates, and wastes safely removed while in solid form. The sumps were so alkaline, naturally, that they were extremely poisonous and could not support any kind of life. Great Salt Lake life: not even those. (These facts not in dispute). In 1987 EPA ruled (under US v. Riverside Bayview) that the lake not regulated by Clean Water Act, so brinewater disposal was allowed. Squires created firm "Laguna Gatuna, Inc.," invested in pipelines from the lake to nearby oil and gas wells.

14. In 1992, the EPA monitored the sumps for water quality. Saturated with salts and heavy metals. Noticed dead birds in the area of the lake: EPA claimed Laguna Gatuna, Inc., had violated Clean Water Act by "discharging" pollutants without the EPA's permission. The EPA claimed the lake "provides a significant nesting, feeding and loafing area for migrating birds, including shorebirds, ducks, coots, grebes and raptors." Natural rainwater accumulates in the sinkholes about once per 150 years, but bottom of holes impermeable. EPA claimed the sump could be regulated by the Clean Water Act because…. Birds landing on these puddles "are engaged in interstate commerce."

15. Did you get that? What moves? The water? Nope; impermeable clay basin. Is this an endangered species action? No. What moves? The birds. The birds are engaged in interstate commerce. The EPA issued a cease and desist order to Laguna Gatuna, Inc., and threatened to impose a $125,000-a-day fine should the company continue to dispose of production water on the land. This was "pre-enforcement," pending an "actual" regulatory decision. But it was not "pre-enforcement" from the perspective of the company, which had to shut down. It asked for compensation for loss of property value, but U.S. Federal District Court in NM / U.S. Court of Appeals said EPA orders under the Clean Water Act are not open to judicial review.

16. So, Squires could not recover damages for loss of the use of the land for its business purpose. No compensable taking, under the 5th Amendment, given the regulatory public interest. Squires tried continuously to get compensation. Then, in 2001, the Supreme Court struck down the Migratory Bird Rule under the Clean Water Act in SWANCC v. U.S. Army Corps of Engineers. Squires was certain that he could get compensation now. The response of the EPA is breath-taking. Guess?

17. Remember, it was a pre-enforcement ruling. It turned out, on review, that the limits on operating the business were ultra vires (beyond the power of the law.) Therefore, the EPA could not possibly have taken the use of the land, because the law didn't allow it. It was all "pre-enforcement." Thus, according to the EPA, Squires had a remedy: he could have continued to operate the business, and pay the $125,000 per day, for nine years. Just to be clear, that would have been cumulative fines of more than $400 million dollars. The EPA said that they would have refunded the fines in full, once the pre-enforcement process had been completed. But since Squires had "voluntarily" settled, they had not proceeded, and never discovered the action was ultra vires. So there was no loss to Squires, and no compensable "taking" at all. It was not a real decision, because it was all a pre-enforcement settlement. Caused THIS reaction from the federal judge…

18. Settled In September 2001, the U.S. Court of Federal Claims ruled in his favor. The court found that the Laguna Gatuna's numerous investments made in anticipation of future company progress had been destroyed by the EPA's regulatory order. Consequently, the agency's action constituted a "taking" that warranted compensation. Squires received $2 million in compensation. Almost all went to pay legal fees. He died a few months later.

19. 3. Delegation

20. Transantiago: The Bus System Reform--Delegate to National Agency Problems with old system • Danger from accidents • Chaos at bus stops • Pollution • Congestion from too many buses/cars • Profits (WTF?) Social capital…passed money forward, change back.

21. TranSantiago Two Problems: Greed and Danger Greed: Profits of $60 m US per year Danger: Accidents, because curb rights were common pool

22. TranSantiago

23. Time Mag, 12-07: “The Mass Transit System From Hell” Amid the apartment blocks and flyovers of the Chilean capital, Monica Eyzaguirre joins the snaking line of people at a bus stop, unfolds her newspaper & prepares for a long, long wait. "I hate Transantiago with every bone in my body," she says of the city's widely despised new transit system, watching a bus heaving with passengers trundle towards her down a congested road. "I used to take one bus to work and now I have to take three. It's made the lives of millions of people more difficult and more miserable.“Read more: http://www.time.com/time/world/article/0,85991694607,00.html#ixzz13eemmlVA

24. NPR Story, October 2007 While a state-of-the art system installed in Chile has reduced pollution in Santiago, a bungled adjustment has also left millions of passengers reeling — and hundreds of others suing the government. The new system may be generating less pollution, but it is also generating mountains of complaints. What was once a 40-minute trip can now take 2 hours. As a result, commuters are losing their jobs for being late, or must change jobs because routes have changed. So troubled is Santiago's new mass transit system, known as Transantiago, that President Michele Bachelet made an unusual admission just days after its disastrous roll-out. "It is not common for a president to stand before the nation and say 'Things haven't gone well," Bachelet said in Spanish. "But that is exactly what I want to say in the case of Transantiago. The inhabitants of Santiago, especially the poorest," Bachelet said, "deserve an apology."

25. City Fix Interview (3/2010): Planners’ Attitude… • TCF: Why did officials make the decision to open Transantiago without any bus lanes? • JCM: …There was a perception that the main goal of the system was not to save time, but to reduce accidents, prevent drivers from competing for passengers, and reduce noise and pollution. All these objectives were met from the beginning. But the system was performing so badly that the users could not appreciate these benefits in the face of the poor service they were experiencing. (Juan Carlos Muñoz, PUC Planning/Transport)

26. What Went Wrong? Remember, the problems had been greed, pollution, and danger. Solution was to make it public. Routes Incentives/Greed Profits Social Capital

27. Santiago Bus Route Systems “I used to take one bus to work, and now I have to take three”

28. 4. Democratic Coherence Qualified by majority. "The" majority. But there are many majorities. Two problems: 1. Agenda control 2. Actual incoherence

29. 4. Democratic Coherence If there are three (or more) alternatives, and there is disagreement, then democracy may be radically indeterminate. More simply, there is no correct answer to the question, “What do the people want?” In fact, some majority opposes every alternative.

30. Choices: Food for All Here is the problem: 1 2 3 A C B Best B A C Middle C B A Worst Majority preferences: A > B > C > A Endless, infinite cycling over alternatives. Not a tie, but a literal perpetual motion machine

31. But this is nonsense: meetings end That is what should terrify you: meetings end, and things get decided. The point is that we are rarely presented with three or more alternatives. We usually are presented with two. How are those two chosen? The “John Tomasi Revolution”: coalitions form, charismatic people take power. Not the will of the people, but the force of will of some demagogue or tyrant If the rules matter to this extent, that means that procedures, not preferences, determine outcomes. And elites control procedures…. Real problem: A majority is opposed to every alternative. NOT A TIE!

32.  6. Law is the expression of the general will. Every citizen has a right to participate personally, or through his representative, in its foundation. It must be the same for all, whether it protects or punishes. All citizens, being equal in the eyes of the law, are equally eligible to all dignities and to all public positions and occupations, according to their abilities, and without distinction except that of their virtues and talents. GENERAL WILL??? GENERAL WILL??? GENERAL WILL??? GENERAL WILL??? GENERAL WILL??? GENERAL WILL???

33. What does Democracy look like?

34. 5. Knowledge Problem How to act without prices? Can we manipulate prices to affect how people act?

35. Housing Crisis: A Trap Set by the US Government, Baited with 3 tasty Cheeses. "Tasty" because Suppressed Price Information

36. Effective? Unfortunately… Each trap could catch many!

37. Many Traps--Three Kinds of Cheese, Prices Set by Magic!!!!! • Equity Purchase Subsidies • Artificially Low Interest Rates • Guarantee of Permanent Price Increases

38. 1. Equity Purchase Subsidies: Homes Home ownership policy of Bush, also Clinton: Pay low-income people to make a risky investment that they would otherwise rationally avoid. Mortgage Agencies treated like “public utilities” (Bernanke, Paulson). Banks/financial entities both threatened, and bribed, to make loans that could not possibly be paid back. Community Development Block Grants: subsidize the down payment. "Qualifying" loans: A history

39. 1. Equity Purchase Subsidies: Homes "New Agency Proposed to Oversee Freddie Mac and Fannie Mae,“ By STEPHEN LABATON, September 11, 2003 The Bush administration today recommended the most significant regulatory overhaul in the housing finance industry since the savings and loan crisis a decade ago...The plan is an acknowledgment by the administration that oversight of Fannie Mae and Freddie Mac -- which together have issued more than $1.5 trillion in outstanding debt -- is broken.... (Oxley): ''The current regulator does not have the tools, or the mandate, to adequately regulate these enterprises. We have seen in recent months that mismanagement and questionable accounting practices went largely unnoticed by the Office of Federal Housing Enterprise Oversight,'' the independent agency that now regulates the companies….

40. 1. Equity Purchase Subsidies: Homes Two New York Times Articles: II. “New Agency Proposed to Oversee Freddie Mac and Fannie Mae,“ By STEPHEN LABATON, September 11, 2003 Among the groups denouncing the proposal today were the National Association of Home Builders and Congressional Democrats who fear that tighter regulation of the companies could sharply reduce their commitment to financing low-income and affordable housing. ''These two entities -- Fannie Mae and Freddie Mac -- are not facing any kind of financial crisis,'' said Representative Barney Frank of Massachusetts, the ranking Democrat on the Financial Services Committee. ''The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.'' Representative Melvin L. Watt, Democrat of North Carolina, agreed. ''I don't see much other than a shell game going on here, moving something from one agency to another and in the process weakening the bargaining power of poorer families and their ability to get affordable housing,'' Mr. Watt said.

41. 2. Artificially Low Interest Rates

42. Artificially Low Interest Rates • Why would this matter? Reasons: • Subsidy to long term borrowing • Subsidize risk-taking, lender of last resort • ARMs and Balloons • Buy a house, zero down, 4 year lock-in of 4% , • then balloon payment or ARM. If house was $200k, • and it appreciates at 5% per year, that’s more than $40,000 capital gain. You can refinance, with $40,000 down payment and a standard fixed rate mortgage. It’s all free! As long as housing prices go up forever… • The first rule of finance: Anything that will certainly happen tomorrow actually already happened, yesterday.

43. 3. Guarantee of Permanent Price Increases Example: Interview with Henry Paulson (T-Sec, 2006-Jan 2009), in 2007: Paulson: “I think what we’re doing is avoiding a market failure that would have forced housing values down in a way that was not in the investors’ interest, and in a way that the market wasn’t intended to work.” Interviewer: “How can you force values down? Why aren’t values finding their natural level?” Paulson: “The way values would go down is, as I’ve said, you’d have market failure.” [After Treasury Department intervention] “we won’t have housing prices driven down in ways that distort the market.” The Guarantee: Government SHOULD, and CAN, maintain orderly permanent increases in housing prices.

44. But…How? History: 4 Influences • SECURITIZED DEBT Fannie Mae (1938) and Freddy Mac (1970) set up to “rationalize” the mortgage market—”Securitize.” At first, worked pretty well. Repackaged and commoditized mortgages, so that people with money could loan to people who wanted to borrow money. Didn’t need banks, except as intermediaries. Home ownership is highly illiquid debt; more extensive loan market, with reselling, allowed for increased liquidity among both borrowers and lenders. Reduced transactions costs, lower rates for borrowers, higher rates for lenders. Problems: Risk status endogenous, increase asymmetric information about repayment rates

45. History: 4 Influences • INCREASE HOME OWNERSHIP, CONFIDENCE IN MANAGEMENT OF ECONOMY It seemed home ownership was the stairway to the American dream. Encourage home ownership through (a) tax subsidies, (b) explicit subsidies, (c) pressure banks and regulatory agencies to certify “subprime” loans as “conforming.” Conforming loans require 20% downpayment and 30% cap on monthly income. Both relaxed by regulators, 1994-1997. Problems: None, as long as home prices go up. But investors either didn’t know, or didn’t care, that regulators were expanding the definition of “conforming” loans. Appeared to be good loans, certified by government agencies as being investment grade assets.

46. US Homeownership Rates The new loan products are known as the combo / ballon loan, and have lower down payment requirements. Combo loans are the contract of choice for nearly 40% of new loans, explaining much of the increase in homeownership rate since 1994.

47. At the same point in time, 1997, housing prices started to skyrocket in real terms. Before, housing had been a hedge against inflation, but wealth was built through accumulating equity. Now, with the new loan regime from the Congress and the Clinton administration, and Fred and Fan helping, there was a huge rush of cash chasing houses. US Homeownership Rates

48. History: 4 Influences • COLLATERALIZED DEBT OBLIGATIONS Collaterlized Debt Obligations (CDO)—90% repayment rate means an accurate price for bundles, even if no one security could be priced accurately. Problems: 90% repayment rate is endogenous, assumed old regulatory structure. And assumed steady increase in home prices. When repayment rates plummeted, no idea how to price these very complex assets. Imagine what the bankers thought; they must have been incredulous! “We can certify these lousy risks as investment grade, and then we can sell them in bundles at full price to FM/FM, and then bear NO responsibility for anything that happens later? COOOOOL!”

49. History: 4 Influences • DERIVATIVES, especially Credit Default Swaps Similar to other “hedging” derivatives. “Invented” by JP Morgan analysts in 1997, in 2000 became exempt from most regulation. (Pres. Clinton supported). Like insurance, but NOT insurance. Needn’t own asset, not regulated, and no requirements for reserves or structures of hedged risk layoffs. Problems: “Insurance” aspect of these derivatives meant that no one cared about the underlying assets, and no one investigated repayment rates. And AIG (with its physicists) made huge amounts of money writing these contracts. But like a one-sided betting shop: did not hedge the risk. For many companies, their only assets were these swap contracts after the primary assets defaulted.

50. Prices Are Information, Not Policy No Regulation: You are on your own. No one knows if these assets are risky, and if you lose money no one will bail you out. Really, really bad regulation: Government caused the crisis, by subsidizing housing prices, and using government prestige to hoodwink small investors. Certified junk as conforming, allowed fast resale at full price, facilitated by Freddy and Fanny. “Investment houses” turned into “Animal Houses.” And firms that lost enough money were made whole with public funds. The dilemma: Bad regulation can be worse than no regulation. But can't we "reform"? Wouldn't GOOD regulation be better? Test: When you say, “Government should regulate markets,” take out the word “Government” and substitute “Politicians I actually know.” You sure you still believe that? Confidence, Transparency, Liquidity required for accurate pricing and functioning markets