Saving Capitalism . . .
from the capitalists.
Jan 18, 2010, Vol. 15, No. 17 • By IRWIN M. STELZER
We have met the enemy and he is us. So Pogo might have described the situation that the business community has created for itself. There is no question that the Obama administration, and even more the Democratic leadership in Congress, harbor something between skepticism and hostility towards free markets. They believe they can do a better job of allocating the nation’s resources than can millions of consumers signaling their preferences to millions of producers by setting the cash registers ringing. That’s one reason—indebtedness to trade unions is another—Obama and the Democrats bailed out a manufacturer of cars no one wanted to buy.
But the wave of regulations that characterized the latter part of the Bush administration and the first year of the Obama administration has as much to do with the behavior of the business community, or at least some of its most prominent members, as with the ideological bent of our political masters. Start with George W. Bush—no antibusiness ideologue he—and the much railed-against Sarbanes-Oxley Act.
No matter what one might think of that attempt to solve the problems of corporate book-fiddling, there is no denying that this 2002 statute is a regulatory burden that the business community brought on itself. Company directors, supposed to be independent of the executives they are charged with supervising, simply did not do their jobs. They approved mergers that drove down the price of the acquiring companies’ stock, harming the interests of the owners; acquiesced in estimates of “savings” that had no chance of being realized; allowed stock options to be re-priced and re-dated so that executives who had not met performance standards nevertheless received the same rewards for failure that they would have received for success; and made certain that “their” executives were never paid less than some average concocted by fee-seeking compensation consultants. Little wonder that Congress and President Bush felt it necessary to pass a law that attempted to make certain that directors are indeed independent of the CEO, that no one is cooking the books, and that compensation committees feel at least some pressure to behave as guardians of shareholders’ interests. No surprise that under the new accounting oversight rules the cost of doing business has gone up, and that an excessive aversion to risk-taking might well have been introduced into boardroom deliberations. These costs, which may or may not exceed the benefits of the new regulations, are in the nature of self-inflicted wounds.
Looking ahead, we have the provisions of the health care “reform” act that in effect turns insurance companies into public utilities. Like electric utilities that cannot deny service to anyone requesting it, or cut off customers who do not pay bills without going through elaborate procedures, health insurance companies will have to serve virtually all comers—and at rates for the sick and elderly that cannot deviate from some specified average by more than a statutory-fixed multiple. Actuaries out, politicians in.
The insurers will also have to limit their profits to some stated percentage of their premium charges—utility monopolies have long been subject to such limitations on what they are permitted to earn. Yes, an antibusiness Congress was waiting for an opportunity to get its hands around the throat of an industry that it deems provides a necessary service and has monopoly power—the two broad criteria for utility status.
The insurance industry’s monopoly power does not arise from any natural cause, though, such as the enormous cost of constructing competing electricity transmission lines, or of tearing up the streets of a major city to allow competing gas distribution companies. No, such monopoly power as insurance companies have was created by laws it lobbied for and got—exemption from the antitrust laws, and limitations on competition across state lines. The way the industry saw it, unregulated monopoly power is best, but if that game is up, regulation is to be preferred to competition. Which is why the industry fought to retain its exemption from the antitrust laws—and, to its relief, won.
It prefers the status of regulated monopoly to that of unregulated competitor because it knows the latter makes for sleepless nights, years in which individual company performance might be so poor as to cause heads to roll in the executive suite, and continuing pressure to innovate and lower costs. Regulated status, on the other hand, turns the focus of executive effort from the hurly-burly competitive marketplace to the more congenial, sedate hearing rooms of the state regulatory agencies that are being charged with enforcing the profit limits. It also confers a significant advantage on big companies, and not only because they can comfortably bear the costs of coping with the regulatory process. Small competitors, providing a service that their customers find satisfactory, will find it difficult to keep administrative costs to the percentage of premiums specified in the legislation. Human-scale boutiques out; instead dial 1 for English, wait for customer service, and if you don’t know your account number, well, that’s your problem.
Regulation creates an unequal battle between the law departments and political lobbyists of the insurance companies, and the staffs of the regulatory agencies, even those that are not captured by the companies they are supposed to regulate. In the end, only the bravest regulator will accept responsibility for causing an insurance company to fail by denying it the premiums it says it needs.
The companies know, too, that the health care bill’s restriction on the portion of their incomes they may devote to executive salaries and other administrative costs is not the draconian measure it might seem. For one thing, the definitions of expenses, profits, and the other bookkeeping arcana will be the subject of discussion with the regulators, discussions in which there will be what economists call asymmetric information—the companies know a lot more than the regulator, with limited staff, can ever know.
More important, settled law provides that any regulated entity is allowed to earn on its investment what companies exposed to similar risks do in fact earn on their investment. “That return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and to attract capital,” the Supreme Court noted in a 1944 decision that stands unchallenged. Not a bad prospect for an insurance company, especially as compared with the risks lurking in a competitive marketplace.
It should be obvious that the process of discovering the right number for allowed profit will depend on the selection of comparable companies, the number of years selected as the relevant test period, the theoretical models to be used in these computations, and other stuff that fills thousands of pages of utility proceedings and provides testifying fees for accountants, rating agency staff, and economists (not excluding this writer). The acknowledged dean of regulatory economists, Cornell professor emeritus Alfred E. Kahn, notes in his authoritative two-volume study that “the very idea of the ‘correct’ rate is elusive,” and Roger Morin, a Georgia State University professor who specializes in this field, writes, “there are no hard-and-fast rules, no mathematical formula or scientific panacea that can be mechanically and infallibly applied.”
There is, of course, the possibility that some small-minded regulators will occasionally deny a company what its executives and counsel deem a fair return on its investment. In that event, the battle will move to the courts. More costs, more fees. A small price to pay to avoid the greater evil—competition.
But this process leaves the executives with market shares largely intact, jobs secure, and little need to innovate since there are no competitors to contend with and even the best regulators have no ability to create a Schumpeterian wave of creative destruction. Doubt that, and compare the innovations in the telecommunications industry since competition was introduced by a combination of deregulation and antitrust action. Try to recall when you needed permission from AT&T, protected by its regulators, to attach to its system what was called a “foreign device”—in my case a shoulder rest on a telephone hand set, an answering machine, and what was then called a “designer phone” rather than the black instrument, then the only one provided by Western Electric, the AT&T-owned monopoly equipment supplier. Compare that with the plethora of devices and networks now available.
If you still doubt that Pogo had it right, consider the problem of bankers’ pay and bonuses, huge sums for doing what the boss of Goldman Sachs calls “God’s work”—his refutation of the biblical notion that it is impossible to serve both God and Mammon. Nothing offends bankers and their conservative allies more than the fact that a “pay czar,” with implicit powers that far exceed his formal remit, sits in judgment of their estimates of what they should be paid.
Especially now that the major banks, having been bailed out by the taxpayer, have paid back their TARP loans. Leave aside for the moment that bank profits are inflated by the banks’ ability to borrow from the Fed at close to zero interest rates, and use the funds to buy Treasury IOUs yielding a safe return on the order of 3 percent. And that investment banks, those financial innovators and steely-nerved traders, have chosen to seek shelter by getting expedited permission from the government to re-define themselves as “commercial banks,” with special access to the Fed should they get into trouble. Or that some of their debt is still guaranteed by the Treasury. Or that they know they are now considered either too big, or too interconnected to fail—or both. Not exactly the sort of daring risk-takers that they represent themselves to be.
Concentrate instead on the business practices that set the tone in which the debate about bankers’ compensation occurs. These institutions, or at least some of them, think nothing of creating products to sell to their clients, while simultaneously selling those same products short for their own accounts so that they can profit from the expected fall in the value of the securities they are urging their customers to buy. A headline in the New York Times summarized the practice, “Banks Bundled Debt, Bet Against It and Won.” The banks contend that there is nothing improper about this procedure. Perhaps, but the word wrong comes to mind. And to the extent that it is practices such as these that contribute to profits, and hence to bonuses, executives have little reason to be surprised when politicians are put under pressure, or in some cases seize a long-awaited opportunity, to do something. (That “something” often turns out to be the wrong thing, is a matter for another day.)
Finally, consider the airlines, products of the innovative skills of the Wright Brothers and, ever since, the indulgence of the bankruptcy courts. These paragons of customer service somehow couldn’t solve the problem of providing food, water, and clean toilets to passengers stranded for hours on the tarmac on some 1,500 flights over the past 12 months that had what are called taxi-out times in excess of three hours—a tiny fraction of all flights, but this is the sort of thing where anecdote trumps data.
Delays happen, as every experienced traveler knows. But they also know that there is something wrong with a system that incarcerates them in a smelly aircraft only yards from a terminal, and with airline executives who cannot figure out how to parole them. Part of the reason is the lack of competitive necessity to do so, as many routes are dominated by one or a few carriers. Part of the reason is management sloth, or in the case of those who do “care,” sheer incompetence. And perhaps the greater contributor to these delays—Congress’s refusal to fund an updating of our obsolete traffic control system, or better still allow its privatization—is not immediately apparent to angry passengers.
So we now have fines of $27,500 per passenger to be levied against airlines that imprison travelers for more than three hours on the tarmac. Any money collected will go to the U.S. Treasury and not to compensate the passengers who suffered the pain of the wait. Such is the government’s sense of equity.
The industry claims that the forced return to the gate of delayed flights, or surrender of places in the takeoff queue in anticipation of possible runway delays, will result in more cancellations, creating even more inconvenience for passengers. Perhaps. But the carriers have little support for their antiregulation position: Abused customers do not make a natural constituency for private-sector companies arguing against regulatory intervention.
More examples could be marshaled, but they seem unnecessary to prove that Pogo had it right. True, much of the regulation that is being loaded unto American businesses is costly. But equally true, some or much of it could have been avoided if business leaders had not sought relief from the rigors of competition, had understood that politicians will pounce if business practices offend commonsense notions of what is fair and proper, and if incomes, especially high ones, are not broadly related to performance and do not provide incentives against behavior that creates systemic risk.
The policy question to be answered is not whether we should be suspicious of government efforts to supersede market forces. Or whether we should point out the economic costs of regulation. Of course we should. That’s the easy part. The harder question is to decide whether market capitalism is more likely to retain broad support:
• if directors are left free to cater to the executives they are supposed to be supervising, or are pushed in the direction of more fully representing the interests of the owners of the business, the shareholders;
• if insurance companies, just given a gift of 30 million healthy customers who must buy their products, are left free from both competitive and regulatory pressures to set premiums and decide just how much to require insureds to contribute to the profit pot, or have their profits and practices subject to regulatory review;
• if an airline, knowing that all other carriers will act with the same disregard for customer comfort and safety, is permitted to leave passengers on the tarmac for hours on end, without fear of penalty, or is fined to provide an incentive to more kindly behavior;
• if bankers, surviving by the grace of the taxpayer, are free to put bonuses before the shoring up of their capital base, or if some sort of restraint is imposed on their freedom of action, be it by statute or nomination to a Hall of Shame.
It is no good to say that there will be unintended consequences of any move by government to intervene. There surely will—just as there will be unintended consequences of doing nothing to correct abuses that are beyond the ability of markets to correct. My fear is that the latter might just be more damaging to the ability of market capitalism to survive than the former.
Irwin M. Stelzer, a contributing editor to The Weekly Standard, is director of -economic policy studies at the Hudson Institute and a columnist for the Sunday Times (London).
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