The Magazine

Saving Capitalism . . .

from the capitalists.

Jan 18, 2010, Vol. 15, No. 17 • By IRWIN M. STELZER
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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.

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